Today’s podcast features a conversation about what’s ahead in fixed income in 2021. In addition to market outlooks, we’ll focus on ways to generate income and enhance total return. To discuss, we’re talking with George Bory, Managing Director and Head of Fixed Income Strategy and Product Specialists at Wells Fargo Asset Management (WFAM).
Laurie King: I’m Laurie King and you are listening to On the Trading Desk®.
Today I’ll be talking with George Bory, Managing Director and Head of Fixed Income Strategy and Product Specialists at Wells Fargo Asset Management. George has been a guest on our program several times, and today he is going to provide insights about what he and the fixed-income teams at WFAM see ahead in fixed income. Welcome back to the program, George.
George Bory: Hi, Laurie. It’s great to be on the show.
Laurie: Since this is the new year, what do you see ahead in 2021 at the macro level?
George: So Laurie, after a pretty wild 2020, it looks like 2021 will be hopefully not as lively but certainly lively, as well. We got a new administration coming in in DC, we got the rollout of the COVID vaccinations, and we certainly still have ongoing geopolitical tension. So there’s plenty to focus on.
At the market level, it’s very important that our investors remember we have three very dovish personalities pulling the levers of power as we go into this year. We’ve got Jerome Powell at the Fed, we’ve got Janet Yellen, who is going to be at the Treasury, and, as we know Joe Biden, as the president.
Following last week’s chaos in DC, it seems the tendencies to spend, certainly from a political perspective, seem to be running high across both parties. So as a result, some of those benign forecasts that people made at the end of last year—look at risk—and we’ve seen many of those forecasts get revised and revised meaningfully.
I think the only one that seems to be steady as she goes is the Fed funds rate. It’s likely to remain very close to zero. But bond yields are starting to move higher. Expectations are they could rise more than expected. Yield curves have been steepening and credit spreads have kind of reached their tights. So we’re calibrating many of our strategies to reflect these changes and position our portfolios as we go into this year.
Laurie: Well, thanks for the overview. I’d like to tell our listeners that you and the investment specialist team here at Wells Fargo Asset Management have authored an investment perspective called Income Generator: Fixed-income handbook 2021. And it’s available for investment professionals, and they can find it on our wellsfargoassetmanagement.com website. So anyway, this 2021 fixed-income handbook covers a lot of ground, from money markets to investment grade to high yield to global bond markets. And I’m wondering, George, can you tell us were there some common themes?
George: So the basic premise for this year is that fixed-income investors have to focus on two things. Number one: capital protection, and number two: yield enhancement. They’re always important to fixed-income investors, but this year, especially in the early part of the year, we think these factors are going to be paramount.
Interest rate yields from the Treasury have started to move up and out as we move out along the yield curve. Now when yields rise, we know prices fall, and although we get some offset by the income by the yield that the securities generate, they’re usually not nearly enough to offset any material rise in interest rates. So with yields up and likely to continue to move up, we’re telling investors they should focus on shorter duration bonds to protect against any capital loss.
However, as I mentioned before, the prospect of another wave of government stimulus, coupled with the rollout of the COVID vaccine, should help both private and public sector entities to generate some pretty healthy income. So that distribution or redistribution, in some instances, from the federal government out into the rest of the economy is going to be very meaningful as we go into next year. Now that tends to help lower-rated companies, lower-rated municipalities, and typically less-creditworthy borrowers.
So when we think about our strategies—and you talked about our outlook for this year—those themes are really built around those basic kind of assumptions. So for example, in our money market strategies and in our short duration strategies—I mentioned Fed funds expected to be anchored at zero—well, that extends all the way out to the 2-year. The 2-year treasury’s right now around 14 basis points and hasn’t really moved all that much. So we want to continue to extend out the curve, but in our longer duration strategies, we’re taking a more cautious stance. We’re a little bit more cautious further out the curve, and we’re set up for yield curve steepeners to try and benefit from kind of rising yields out at the long end of the curve.
Now when we look across all strategies, we still have a bias to go down in quality. The power of government spending should never be underestimated. The federal government is a pretty powerful entity when you think about their impact on growth and earnings and the way that cash—that is extra earnings flow—to the users of that money is a direct benefit to the lenders, which would be any issuer or any investor in corporate bonds and municipal bonds and commercial paper, and we want to be able to set up to benefit from those types of trends.
Laurie: So let’s dig into some specific areas of fixed income, starting with cash and short duration. As you mentioned, safety and liquidity is a priority, but now that U.S. companies have raised record amounts of cash in the wake of the pandemic, what kind of strategies are cash and short-term investors looking at?
George: As I mentioned, yield enhancement’s key at the front end of the curve. And like I said, the Fed is on hold until sometime, we think, until 2022. That keeps the yield curve all way out to 2-year pretty fully anchored, and even as we go out a little bit further, the curve does start to steepen as you go out to the 3-, 4-, and 5-year part of the curve, but the steepening’s been pretty modest and in relatively muted.
As I mentioned, the 2-year Treasury at 14 basis points is not a heck of a lot of yield. So yield curve extensions out to 3-, 4-, and 5-years still makes sense to us.
As you mentioned, money market funds, whether it’s corporate cash or even individual holdings of money markets, money market funds total roughly $6.5 trillion of cash that’s harbored at very much in the front end of the curve. So our expectation as we go into this year is that some of that money, not all, but some of that money is going to migrate into ultra-short strategies and then things what you might call “cash plus.” That there is a tremendous amount of pressure on the holders of cash to generate some incremental amount of yield and I say “some” because money is intended to be invested in a very conservative strategy. People who hold large portions of cash typically need that money. They need that money kind of on demand. They want to use it in the short term, and so we need to preserve that capital. We need to preserve liquidity, but we need to look for incremental sources of yield.
So we’ll go down a little bit in quality. We’ll also go out a little bit in curve, but we are always looking to preserve that capital and maintain its safety and security. So we’ll see that money move, but it’s going to be incremental and it’s going to be on the margin for the most part over the course of this year.
Laurie: So these two levers that you talked about that can add to diversified income—extending out the yield curve and moving lower in credit—how do those concepts apply to investors with intermediate and longer-term time horizons?
George: Sure, Laurie. Those factors apply to all fixed-income investors. It doesn’t matter whether you’re lending money for one day or 100 years. The trade-off between those two levers are critical.
And when we think about it, incremental yield can only be generated by taking a little bit of extra risk. And for a fixed-income investor, that usually means how much time are you willing to let pass or how much time are you willing to lend money to someone or some entity before you get that money back? Or you could take a look at the type of borrower you’re likely to be willing to lend to, and you may be willing to lead to a less creditworthy borrower.
And in the early stage of an economic recovery, which is what the U.S. economy is in right now, lending for a longer period of time, it can be a bit risky. In the early stages of recovery, inflation does tend to rise. There’s always a debate as to how far and how fast, but as the economy picks up and gains momentum, inflation does tend to pick up.
So you want to be a little bit careful as to how long you’re willing to lend, but some of that risk can be offset by taking some chances with less creditworthy borrowers. They’re the folks, they’re the companies, they’re the municipalities that are likely to benefit from a cyclical upturn in the economy. As I mentioned before, in today’s market, the government seems poised to embark on a meaningful spending spree. That could total as much as $4 trillion this year. Those are the types of numbers that seem to be circulating in DC. These are massive spending programs. That’s roughly 20% of our annual GDP. If that were to come in a fast and furious way over the next 1 to 2 years old, well, that’s going have a meaningful boost to the economy, it’s going to have a meaningful boost to income, and it’s going to actually help a lot of borrowers be able to both pay back the money that they owe and/or generate kind of the income they need to service their debt load. So it would be viewed as credit positive.
So we want to go down in quality right now and we’re just going to be a little bit more cautious on how long we’re willing to lend to folks.
Laurie: So George, what were some of the main points within your recent publication Income Generator: Fixed-income handbook 2021 that were made about core and core plus bond strategies?
George: So the nice thing about core and core plus bond strategies is that they’re pretty diversified. They look at just about every segment of the fixed-income market. So they’re going to look at treasuries, they’re going to look at cash, they’re going to look at corporate bonds, mortgage-backed securities, asset-backed securities, municipalities, international bonds. So we want to cast that net as far and wide as possible, and that is the central theme of a core or core plus strategy. Be as broad as you possibly can.
Being able to protect your capital is about finding the right securities at a particular point in the cycle to maximize your return or minimize your loss in a rising rate environment.
Now the difference between core and core plus, plus will typically go into high yield, as well as into emerging markets and might be a bit more aggressive on the international side. And the benefit of those three segments or those three strategies is that it does add another element of diversification or different elements of diversification to a bond portfolio.
So it really comes down to your tolerance as an investor, if you’re willing to absorb or willing to tolerate those types of risks. But in doing so, when you are willing to do that, you do pick up some nice diversification benefits. So we want to cast the net as far and wide as possible. We want to generate as much income as we can in these strategies, but we also want to maximize the diversification that we can kind of generate as we look across different segments, different parts of the market, and different parts of the world.
Laurie: Now all these topics are timely, but none more so than the U.S. dollar and its trend. We’ll soon have a new Treasury Secretary—Janet Yellen, as you mentioned—and potentially new trade agreements with the new administration. Do these matter to the dollar outlook? And how are you positioning portfolios for the U.S. dollar down trend?
George: Laurie, the value of the U.S. dollar’s one of the most important inputs that our investors and our clients need to consider over the next 12 months.
Over the long term, the dollar has been moving lower. And in short, we expect that to continue over the course of 2021. But we are coming off a period of pretty impressive cyclical strength. Last year, the U.S. dollar declined about 10% from the highs that we saw back at the early part of 2020 versus a broad basket of other currencies.
And as we think about this year and as we think about the next couple years, I think the short message is we expect the dollar to continue along that path of weakness. Now this is going to be led by three specific factors.
First, the cyclical upswing in growth is more than just a U.S. story. It’s a global story. And the global nature of the growth rebound allows other currencies to outperform the U.S. This is really the cornerstone of our thesis.
Secondly, the central bank and the U.S. Treasury are determined to keep the Fed funds at effectively zero to bolster inflation. And keep in mind, Janet Yellen is set to become the head of the Treasury and will be working pretty much hand-in-hand with Fed Chairman Powell, both of which worked together at the Federal Reserve over many years. We have two like-minded individuals with very dovish tendencies that are likely to try and restoke those inflation numbers.
And then thirdly, you mentioned trade agreements. It’s our expectation that while trade agreements are likely to persist that the hostility that the prior or the outgoing administration has employed to implement their trade agreements are likely to be less hostile going forward, which also could help bolster other currencies away from the dollar.
When we take all those combined, we expect the dollar to weaken a bit over the course of 2021, but as we’ve seen over the last couple of days, it’s really important to remember that this never happens in a straight line, that there will always be bouts of strength within this kind of broader trend of dollar weakness. And in any event, we’re trying a position portfolios for that downtrend.
Laurie: Thanks for that. And there will be a new edition of Income Generator in January that explains our U.S. dollar outlook and the implications in more detail. So George, any last thoughts for our listeners to tie together all the ideas we’ve discussed today?
George: COVID and politics will likely dominate investor sentiment, certainly in the early parts of 2021, as we’re seeing already. And to that end, rates are likely to rise. We think the dollar should weaken, and we expect credit spreads across pretty much all forms of non-treasury and non-government bond issuance to tighten.
However, as the year unfolds fundamentals should ultimately assert themselves, and we want our portfolios to be aligned with what we think will be a successful rollout of the COVID vaccinations, better economic growth, and some upticks in inflation.
So to position portfolios, we like lower rated credits with short duration and higher yields. Now this would include things like short-term high-yield bonds, leveraged loans, lower-rated municipal bonds, and lower-rated securitized products that help generate cash flow streams that are very attractive in this kind of environment.
As always, performance will ultimately be determined by really how deftly we position our curve allocations in portfolios. Astute credit selection is certainly always the cornerstone of our portfolios and we really need to be very careful about default maintenance and default avoidance. Default rates are likely to come down, but they’re not at zero. So there’s still some risks out there that investors need to monitor.
Now we as a group, as hopefully many of you know, are well positioned to implement these strategies. And our main concern over the course of this year is really we need to protect our clients’ capital and really maximize income generation where appropriate. We feel we’re well set up to do that. We look forward to doing it this year, as well as years in the future.
Laurie: Well, thanks so much for joining us today, George.
George: Thanks a lot, Laurie.
Laurie: That wraps up this episode of On the Trading Desk. If you’d like to read more market insights and investment perspectives from the fixed-income teams at WFAM, you can find them at our AdvantageVoice® blog, as well as by visiting wellsfargoassetmanagement.com.
To stay connected to On the Trading Desk and listen to past and future episodes of the program, you may subscribe to the podcast on iTunes, Stitcher, or Overcast. Until next time, I’m Laurie King; take care.
100 basis points equals 1.00%. GDP stands for gross domestic product. Diversification does not ensure or guarantee better performance and cannot eliminate the risk of investment losses.